One of the Many Challenges Business Leaders Face Today

by Inya Ivkovic, MA

It has been said many times over that the only force powerful enough to pull the global economy out of the recession is going to be the global consumer. This is true, provided that businesses around the world are also included in this category. Namely, unless companies begin to invest again in new opportunities, such as throwing themselves into developing new products, building new facilities, or even venturing into new business lines, no true recovery will ever materialize. However, how can responsible management even think of new investments these days when everything appears too risky and when volatility is still sending powerful tremors through the global economy?

Part of the problem is that business conditions have deteriorated so much lately that most managers are extremely hesitant to part from their cash. Another problem is skewed valuations, or rather the impossibility of correctly evaluating the attractiveness of a new investment with so many unknown factors and variables transforming ordinary equations into an indiscernible mess.

Two critical pieces of information are needed when evaluating new investments: what potential profits might be generated and what minimum returns would such an investment require to offset any risks it entails? Unfortunately, given the volatilities on a macroeconomic level, extracting information that business managers could rely on even at a bare minimum level has become an impossible task as of late. As a result, and not surprisingly, many companies have simply given up on the investment game and opted to wait until the global economic climate stabilizes.

Which is a shame really, because, on closer inspection of what returns investors expect from financially healthy and strong companies, it turns out the financial crisis appears to have had little impact on the actual cost of capital. It is an oxymoron that, historically, the cost of capital has budged very little in an environment where investors facing greater risks would normally expect greater returns that come at greater costs. True, as stock prices have declined sharply and as the credit crisis has proven crippling, many businesses are having difficulty raising funds compared to easy money flows of the past.

Yet, recently conducted studies indicate that, after removing inflation effects, the cost of capital (e.g. equity financing) has remained rather stable. To illustrate, during the period from 1963 to 2001, despite numerous recession bouts, wild economic expansions and financial bubble-induced crises, the cost of equity financing in the U.S. has held at a steady pace of between six percent and eight percent. More to the point, other developed countries have produced similar results.

Of course, contrarians will argue that many things about the financial and credit crisis of 2008/2009 are different compared to any of the years within the above-mentioned study period. However, the researchers argue that the reason stock markets are tanking lies in the declining future profit differentials caused by the recession. Moreover, while the cost of equity financings may differ from one sector to another, and significantly in some cases, overall costs have changed very little, by less than one percent, which is well within the historical bands. (Notably, a similar pattern has been observed in case of debt financings of investment grade companies. Apparently, investors are not demanding risk premiums significantly higher than what they had demanded in the past. Instead, strong demand for government bonds appears to be the culprit behind higher spreads.)

Of course, while the cost of capital and the fact that such costs have not deviated significantly from their historical level are working in favor of business managers, the fact remains that future profit streams are still very difficult to predict. On the other hand, future profit streams were always difficult to predict, even when the overall faith in the global economy, however misguided, was at its peak.